Private Banks : Treasuries Departments and proprietary asset allocation

In this article, Quentin CHUZET (ESSEC Business School, Global Bachelor in Business Administration (GBBA), 2019-2023) explains about Private banks Treasuries Departments and the challenges of proprietary asset allocation.

Introduction

Within the Treasury Department of a Private Bank, the role of its employees is to record incoming and outgoing cash flows, as well as to direct the allocation of assets that comprise its Treasury. Thus, on one hand, we find the amount of cash on the asset side, and on the other hand, on the liability side, the amount of client deposits. In other words, it can be said that the Treasury is primarily constituted by the various deposits made by clients.

These are grouped into 2 categories: sight deposits (money visible in the client’s bank account, available and usable at any time) and term deposits (money placed generally in interest-bearing accounts but only available once the placement has matured).

Private Bank balance sheet

Source: La Finance Pour Tous

To address performance and revenue challenges, the Treasury department manages cash by investing it in interest-bearing products, aiming to generate significant margins. This activity, performed by the Middle and Front Office teams, is referred to as proprietary trading or prop asset allocation.

Before the 2008 financial crisis, the regulatory environment was less stringent, granting banks greater freedom in risk management. However, the crisis highlighted the dangers of this approach, leading to a significant strengthening of regulations.

In 2013, Basel III introduced one of the most important regulatory agreements in banking. It aims to enhance the resilience of banks by increasing their capital and liquidity requirements. Basel III notably introduced a short-term liquidity ratio (LCR) and a long-term liquidity ratio (NSFR).

Regarding liquidity, private banks must now hold sufficient liquid assets to withstand mass deposit withdrawals. They must also comply with a liquidity coverage ratio (LCR), requiring them to have enough high-quality liquid assets to cover their net cash outflows over a 30-day period.

In terms of solvency, private banks must now comply with a capital adequacy ratio (Cooke ratio), requiring them to have sufficient capital to absorb potential losses. Basel III also introduced a leverage ratio, limiting banks’ leverage.

To ensure compliance with these new regulatory frameworks while continuing to maximize revenue, banks have implemented treasury policies and control ratios to define limits and mitigate risks. These treasury policies, spanning multiple pages, guide Front Office teams in asset allocation to maintain the most efficient risk/return ratio possible. It is important to note that each bank has its own risk level, hence treasury policies and their respective limits may vary from one bank to another.

In general, a bank tends to favor a very low-risk level by prioritizing assets that can be quickly liquidated while limiting exposure to interest rate fluctuations or certain sectors. In the risk management process, liquidity and solvency ratios are monitored, as well as ratios related to interest rate risk and non-systematic risk.

Treasury Policy

These Treasury policies, spanning multiple pages, guide Front Office teams in asset allocation to maintain the most efficient risk/return ratio possible. It is important to note that each Bank possesses a risk level unique to itself, which is why Treasury Policies and their constituent limits may vary from one to another.

Thus, this document is divided into several limits and control ratios aimed at protecting against incurred risks. Among the main ratios present in the Treasury Policies, we find:

Liquidity and solvability ratios

Among liquidity and solvability ratios, controls are placed on the recovery time of securities held by the Treasury, with constraints notably regarding recoverable assets within 2 days and those recoverable within 30 days. Through these ratios, the average lifespan of the portfolio is controlled as well as the maximum duration of the securities, as well as the portion of assets placed with the Central Bank, ensuring a high rate of return in periods of high rates and near-immediate liquidity, as it is possible to recover from one day to the next.

These ratios aim to protect against the greatest risk a bank may face: that of illiquidity. This risk is heightened during crises and when clients wish to make massive withdrawals. The bank must thus ensure that all liquidity can be returned.

Security portfolio allocation’s ratios

Through these ratios, the Bank adheres to exposure limits by sector, industry, or company outlined in the Treasury policy: the leverage ratio is a significant indicator. This allows for diversification of allocations and investments and thus frees from specific risk. There are also control ratios based on Moody’s, S&P, and Fitch ratings or ESG ratings.

Finally, there are also ratios aimed at calculating the share represented by each asset class. It should be noted that each asset class represents what is called a “position” in the Treasury Sheet. In other words, each different class represents a different line. Among these lines are placements in the Money Market (Bond Portfolio, NEUCP Portfolio, placements in OPC funds), term interbank loans, currency and rate SWAPs, etc.

Sensitivity ratios

Through these ratios, the Treasury department controls the sensitivity to rates faced by Treasury assets. The Treasury Policy indicates threshold limits that should not be exceeded to ensure optimal rate adjustments, in the event of both increases and decreases.

Risk Management and Asset Allocation

Managing liquidity and solvability risk

To manage liquidity risk as effectively as possible, Private Banks can consider various strategies:

• Purchase securities eligible for ECB refinancing
• Maintain a high proportion of assets placed at the Central Bank on a daily basis (as they are highly liquid and yield interest at times of high interest rates).
• Maintain a short maturity of the security portfolio and short-term deposits.

Interest-rate risk management

Interest-rate risk is a major issue for Private Banks, since a change in interest rates would have a major impact on the yield and price of bond holdings. The sensitivity of an asset represents the length of time during which it cannot be subjected to a variation in its interest rate. Thus, depending on the prevailing trend surrounding interest rate movements, Treasury Traders must invest to maintain a balanced sensitivity ratio. For example, in a scenario where the market strongly expects a future rate decrease, a strategy aimed at maximizing the adjustment period to the rate and thus the sensitivity ratio may be the best option. Conversely, in a scenario where the market anticipates a significant rate hike in the upcoming period, reducing the adjustment period to the rate for the portfolio would allow a quick re-indexing to a higher rate and reduce the time during which those assets would be “under-earning”.

Specific risk and diversification

A specific risk is linked to a particular event, affecting a single company, a sector of activity or a specific financial instrument. It differs from systemic risk, which affects the entire financial system. To reduce this risk, diversification is a key element, which is why a Private Bank can specify limits by sector or asset class in its Treasury Policy.

Therefore, the Treasury department of the Bank and its Front Office teams can allocate their assets to government bonds, as well as to corporate bonds in sectors such as retail, energy, or Real Estate.

Conclusion

In conclusion, the challenges of asset allocation within the Treasury of private banks are manifold. Guided by Treasury Policies, limits, and control ratios, it must adapt to the emergence of a new regulatory environment to define low-risk, high-liquidity investment strategies while addressing performance and revenue maximization objectives. Furthermore, proprietary asset allocation drives private banks to enhance their internal resources and develop tailored management tools.

Why should I be interested in this post?

If you’re interested in proprietary asset management, or in the workings of a treasury department within a private bank, you’ll find a first overview of these topics in this article.

If you have any questions about the position or the sector, please don’t hesitate to contact me on my personal Linkedin page, I’ll be delighted to answer them.

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Useful resources

La Trésorerie active d’une entreprise

Banque-Trésorerie

Le Bilan d’une banque

Liquidité, solvabilité et crise bancaire : quelles relations ?

Diversification et gestion des risques

Les placements d’une Trésorerie d’entreprise

Le risque de taux

About the author

The article was written in March 2024 by Quentin CHUZET (ESSEC Business School, Global Bachelor in Business Administration (GBBA), 2019-2023).

Venture Capital 101: A Quick Overview

In this article, Alessandro MARRAS (ESSEC Business School, Global Bachelor in Business Administration (GBBA), Exchange Semester, September 2023-December 2023) gives a quick overview of Venture Capital.

What is Venture Capital?

Venture capital (VC) is a specialized form of financing where investors provide funds to startup or early-stage companies with high growth potential. This funding is crucial for startups to develop and expand their business operations. Venture capitalists not only provide financial support but also offer expertise and guidance to help these companies succeed. The goal of venture capital is to generate significant returns by investing in innovative businesses that have the potential to disrupt markets and achieve substantial growth.

VCs have five main functions:

• They serve as financial intermediaries, channeling capital from investors into promising portfolio companies.
• Their investments are directed towards private companies, making them illiquid assets.
• VCs actively participate in the management and oversight of their portfolio companies, embodying active investors.
• The primary objective of VCs is to maximize financial returns, typically through strategic exits like acquisitions or IPOs.
• VCs prioritize investments in entrepreneurial ventures with substantial growth potential, aiming to foster internal growth and increase the likelihood of successful exits. These characteristics highlight the dynamic and strategic nature of venture capital investments, contributing to innovation and economic growth.

VCs vs others:

• VCs differ from angel investors as they function as financial intermediaries rather than investing personal funds directly.
• Unlike mutual or hedge funds, VCs invest specifically in private companies, placing them within the category of private equity and alternative investments.
• While all VCs are private equity funds, the inverse isn’t true; not all private equity funds engage in venture capital.
• VCs set themselves apart from crowdfunding platforms by actively participating in the companies they invest in, providing ongoing monitoring and management support.

How are VCs organized?

Venture capital firms are typically organized as limited partnerships, structured to facilitate investment activities while providing a degree of protection and incentive for both investors and managers. For investors this protection comes in the form of limited liability, meaning their risk of losing money is confined to their investment amount and they are not personally liable for the debts of the business. This allows them to invest in high-risk ventures with a capped downside. For managers the incentive is often structured as carried interest, a share of the profits of the investments, which aligns their financial interests with the success of the firm’s investments. This ensures that managers are motivated to select and nurture companies that will yield high returns, thereby directly linking their compensation to their performance in managing the venture capital firm’s portfolio.

Limited partnerships in venture capital consist of two main categories of partners. Firstly, there are limited partners, who contribute capital to the fund and bear limited liability. These investors can include wealthy individuals, banks, mutual funds, and other institutional investors. Secondly, there is the general partner, responsible for managing the fund’s operations and investments, and who assumes unlimited liability. Figures like Don Valentine, Ben Horowitz, and Peter Thiel are examples of notable general partners in the venture capital industry.

The lifespan of a typical limited partnership in venture capital is around ten years, during which investors’ capital is committed and cannot be withdrawn. General partners receive compensation in the form of a management fee and a share of the profits generated by successful investments, known as carried interest.

Limited partnerships offer tax efficiency, as they are not subject to corporate taxes, with partners instead paying taxes on their share of the profits. Additionally, distributions of securities to partners incur no immediate tax implications, with taxes only due upon the eventual sale of the securities.

This organizational structure provides a framework that incentivizes efficient investment management and aligns the interests of both limited and general partners in achieving successful outcomes.

Benefits of VC

Venture capital offers a range of benefits to both entrepreneurs and investors, fostering innovation, driving economic growth, and facilitating wealth creation. Firstly, venture capital provides crucial funding to startups and early-stage companies that may otherwise struggle to secure financing from traditional sources such as banks or public markets. This injection of capital enables entrepreneurs to pursue ambitious ideas and develop groundbreaking technologies, driving innovation across various industries. Moreover, venture capitalists often bring valuable expertise, networks, and mentorship to the table, helping startups navigate challenges, refine their business strategies, and accelerate their growth trajectory.

Secondly, venture capital plays a pivotal role in job creation and economic development. By supporting high-growth startups, venture capital investments fuel job creation, as these companies expand their operations, hire new talent, and contribute to local economies. Additionally, successful startups can spawn entire ecosystems of suppliers, service providers, and complementary businesses, further stimulating economic activity and driving regional prosperity.

Furthermore, venture capital investment offers attractive returns for investors willing to accept the inherent risks associated with early-stage ventures. While venture capital investments carry a higher risk of failure compared to traditional investments, they also offer the potential for substantial returns on successful exits, such as acquisitions or initial public offerings (IPOs). As a result, venture capital serves as a vital asset class for investors seeking diversification and opportunities for outsized returns in their investment portfolios.

VC Financing Cycle

The Venture Capital Financing Cycle delineates the sequential stages of funding that startups typically undergo, from inception to exit. This cycle starts with the Seed Stage, where initial capital is raised to prove concepts and build prototypes. As the startup matures, it may progress through various rounds of funding—Angel, Series A, Series B, and beyond—each designed to fuel growth, product development, market expansion, and operational scaling. The Bridge stage serves as a critical juncture for preparing more mature startups for substantial future rounds or positioning for exit strategies. The cycle culminates in the Pre-IPO and IPO Preparation stages, where companies ready themselves for public offering or seek acquisition opportunities, marking the exit phase. This framework not only structures the investment landscape but also maps the growth trajectory of startups. The VC financing cycle is emblematic of the symbiotic relationship between investors seeking to maximize returns and startups in need of capital to fuel their growth ambitions, fostering innovation and economic development within the broader ecosystem.

VCs financial performance in 2023

In 2023, the venture capital (VC) market experienced significant shifts, reflecting broader economic challenges and evolving investment trends. The year saw a considerable downturn in VC investments, dropping to the lowest levels in four years, with a year-over-year decrease of 35% from the already declining levels of 2022. The total amount raised by VC-backed startups barely surpassed $140 billion, influenced notably by a few mega-deals in the artificial intelligence (AI) sector. The decline was not just in the amount raised but also in deal volume across nearly all fund classes, reaching the lowest point in a decade. Later-stage investments saw the most significant reduction in dollar volume quarter-over-quarter, while Series A investments showed some resilience with a 9% increase.

The backdrop of economic headwinds, valuation concerns, and an overhang of more than 50,000 existing VC-backed startups created a challenging environment for new investments. VC fund formation also experienced a sharp decline, dropping 62% from the record year in 2022, although there was a slight uptick in the last quarter of the year. This situation has led to increased caution among venture capitalists, with a notable reluctance to engage in mega-round financing. Only 50 mega deals were recorded in the last quarter of 2023, marking the lowest total since 2017.

Despite these challenges, AI continued to garner significant attention and investment, driving many of the largest deals in the U.S. during the last quarter of 2023. This trend suggests that while the overall VC investment has declined, specific sectors, particularly those related to technological innovation and AI, continue to attract substantial interest and funding.

Why should I be interested in this post?

As an ESSEC students interested in finance, this post can be a useful resource due to its relevance in the financial sector. Understanding venture capital offers insights into alternative investments, career opportunities in private equity, and the dynamics of financing innovative startups, enriching your knowledge and potential career paths within the finance industry.

Related posts on the SimTrade blog

   ▶ Louis DETALLE A quick presentation of the Private Equity field…

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Useful resources

Zider B. (1998) How Venture Capital Works Harvard Business Review.

Jeffrey Grabow (29/01/2024) Will venture capital market rebound in 2024 or seek new floor? EY

KPMG Venture Pulse Q4 2023

Deloitte 2024 trends in venture capital

About the author

The article was written in March 2024 by Alessandro MARRAS (ESSEC Business School, Global Bachelor in Business Administration (GBBA), Exchange Semester, September 2023-December 2023).

Multiples valuation method for stocks

In this article, Jorge KARAM DIB (ESSEC Business School, Master in Strategy and Management of International Business (SMIB), 2024-2025) introduces the method to evaluate stocks called “multiples valuation”.

How much should a stock be worth?

Valuing stocks is a complex yet essential endeavor for investors seeking to make informed decisions in the financial markets. Knowing if you are paying a fair price or if you are over or under paying for a stock is every investors question. Of course, a decision on whether investing or not in a company comes after a long due diligence of valuating the financials of the company, following their reports, and many more actions to ensure you are buying something of value. Some investors call this method “value investing”, when the investor value a stock above the actual price, it is said that the type of investing is “value”, trying to take advantage of the differential between the actual price and the theoretical price. And when they buy a stock for a competitive advantage that is not expected in the near future to concede, it is usually called “growth investing”. Although some famous investors disagree in these definitions, they are used frequently in the financial language.

While there is no one-size-fits-all approach to valuing stocks, investors often turn to a range of methodologies, one of which is multiples analysis. By examining multiples such as price-to-earnings (P/E), price-to-book (P/B), and price-to-sales (P/S), and many more, investors gain insights into how the market values a company relative to its earnings, assets, or revenue. In this article we will try to shine a light on this valuating method and walk through the benefits and limitations the method has.

Multiples valuation method

Multiples valuation method involves analyzing one or more multiples, such as the price-to-earnings (P/E), price-to-book (P/B), and price-to-sales (P/S) ratios, among others. Each multiple provides a unique perspective on how the market values a company relative to its earnings, assets, or revenue.

The price-to-earnings (P/E) ratio, for instance, compares a company’s stock price to its earnings per share (EPS), indicating how much investors are willing to pay for each dollar of earnings generated by the company. A low P/E ratio may suggest that the stock is undervalued, while a high P/E ratio could indicate overvaluation.

One key aspect of this method is that it is usually compared against the ratios of companies within the same industry. It is from the investor’s criteria to decide which filters to apply for deciding against what companies the objective should be compared with, but usually it should be on the same market, region can also be an important factor, and also the size.

There are many sources of information to consult the information from, many of them free. This platform simplifies the valuation by providing not only the information, but in some cases, the ability to connect through an API and do the consulting automatically through a query. In the next image is shown an example from Capital IQ, one of the most prestigious information sources in the financial world, about Walmart and some recommendations from the platform of similar companies in the market to facilitate the calculation.

Walmart’s comparison.

Source: Capital IQ.

Calculations

Calculating multiples involves straightforward mathematical formulas that utilize key financial metrics derived from a company’s financial statements. If we use the case for P/E, then we would need to divide the “Market price per share” with the “Earnings per share”. After getting the ratio, let’s say of Walmart, the next step is to get the median P/E for the “similar” companies that the investor decided to compare the company with. With these two values the investor can start seeing a trend on where the company is positioned versus their competitors. The next step is to calculate the price per share of Walmart using the P/E of the similar companies, and see the comparison between the price with the original P/E versus the “mean” of similar companies.

Example: Walmart

This section will be dedicated to illustrate the method explained earlier using Walmart as an example and Capital IQ as the source of information. The first step is to consult the key financials as shown in the next picture.

Walmart’s key financials.

Source: Capital IQ.

Next, compute the information with the comparable companies suggested by Capital IQ. Important to note that the companies can be added or withdrawn according to everyone’s own criteria.

Comparable analysis.

Source: Capital IQ.

After retrieving all the information, the next step is to do the calculations explained earlier in the document. The mean EV/EBITDA ratio for the comparable companies and then recalculate the price of Walmart’s stock using the mean EV/EBITDA ratio.

Mean EV/EBITDA ratio.

Source: Capital IQ.

Valuation of Walmart’s stock.

Source: Capital IQ.

In this case, we see an underappreciation of Walmart’s stock, this doesn’t mean that anyone shouldn’t buy stocks of the company, is just the perspective of the valuation method, and also it is not an investing advice.

Conclusions

The multiples valuation method provides investors with a valuable framework for assessing the worth of a stock by comparing it to similar companies within the same industry. By using this method, investors gain insights into how the market values a company relative to its earnings, assets, or revenue.

However, it’s important to recognize the limitations of this approach. Multiples analysis relies heavily on historical financial data and may not fully capture future growth prospects or qualitative factors such as industry dynamics and competitive positioning. Additionally, multiples are subject to fluctuations in market sentiment and may not always reflect the intrinsic value of a company accurately.

Despite these limitations, multiples analysis remains a widely used and valuable tool in the arsenal of investors. When applied judiciously and supplemented with thorough research and analysis, multiples can provide valuable insights into a company’s valuation and help investors identify potential investment opportunities.

Why should I be interested in this post?

This post is with the only intention for educational purposes. Targeting people who are interested in knowing more about valuation methods for stocks. In any way this article pretends to be an investment advice and/or suggestion. Any decision should be taken under personal responsibility and with their respective due diligence previous to the decision.

Related posts on the SimTrade blog

   ▶ Ghali EL KOUHENE Asset valuation in the Real Estate sector

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Useful resources

McKinsey & Company The right role for multiples in valuation

Chastenet E. and A. Marion (2015) Valuation Using Industry Multiples: How to Choose the Most Relevant Multiples, Business Valuation Review, 34(4): 173-183.

Schueler A. (2020) Valuation with Multiples: A Conceptual Analysis, Journal of Business Valuation and Economic Loss Analysis, 15(1) pp. 20190020.

About the author

The article was written in March 2024 by Jorge KARAM DIB (ESSEC Business School, Master in Strategy and Management of International Business (SMIB), 2024-2025).